The Future of Exchanges Is Now

The coming months will be crucial for financial marketplaces as they seek to reinvent themselves. Here are the key areas that offer opportunities for growth—and risks of decline.

By

Jacob Bunge

October 10, 2011

It's going to be a pivotal year for the world's financial exchanges.

For years, the exchanges enjoyed soaring volume as they shifted their trading operations to computer systems from crowded trading floors. Now that boom is petering out—and the financial crisis has dented the turnover in stocks and derivatives.

So exchanges are seeking a new way forward. They're looking to grow by sealing mergers, investing in more profitable businesses and capturing segments of trading that have long remained out of their grasp, everything from exotic derivatives to bonds.

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How it all plays out will have profound implications—for corporations looking to raise money and investors of all sizes, as well as big and small exchanges around the globe.

Investors, for instance, may get access to a broader range of products and platforms. And a shrinking number of exchanges could wield more power and have a wider reach.

But the exchanges' plans could be scuttled, or scaled back substantially, by regulators. Authorities in Asia and the U.S. sank big merger plans earlier this year, and Europe is about to weigh in on another. In other cases, government officials want to give exchanges more leeway to trade exotic investments but are struggling to finalize details.

Whatever the results, the coming 12 months will be crucial for the half-dozen companies that dominate billions of stock, futures and options trades every day, and make up the bulk of the sector's collective market cap of $97 billion. The sector is regrouping after a decade that brought splashy IPOs, a bout of consolidation and a financial crisis that at first looked like a gift, as exchanges' trading systems stood up under stress. But the economic slowdown and ensuing stock-market swings drove banks and investors to scale back trades, while upstart exchanges grabbed more business.

Here's a look at what the exchanges are facing in the year ahead.

Mergers

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William Duke

This year, a feast of cross-border deal-making by exchanges fell apart as countries sought to protect domestic markets from foreign takeovers and regulators threw up blockades. Singapore Exchange Ltd., London Stock Exchange Group PLC, Canada's TMX Group Inc., IntercontinentalExchange Inc. and Nasdaq OMX Group Inc. all were forced to walk away from mergers.

Now some of the failed partners are regrouping or looking at new opportunities. LSE has confirmed a bid for London-based clearing firm LCH.Clearnet, which has also drawn interest from Nasdaq. And LSE and SGX have been reported to be evaluating bids—or a joint bid—for the London Metal Exchange.

In the near term, one major deal is still moving ahead: the combination of Deutsche Börse AG and NYSE Euronext. If it closes in late December as planned, the pact would create the world's largest combined platform for share listings and the busiest futures market.

For exchanges, linking up makes perfect sense. They can not only stake out territory abroad and link up with brands like the NYSE, but also achieve economies of scale. Unifying technology across disparate trading systems allows more trades to be done more cheaply.

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"From a profitability standpoint, it's better for the exchange to be bigger," says
Mike Bingle,
managing director with private-equity firm Silver Lake Partners and overseer of its investments in exchanges. "They get to leverage their cost structure, technology, and all the money they spend on sales and marketing."

In theory, investors get cheaper trading costs and access to more stock, futures and options markets. There are implications for companies that offer stock, too. If a combined exchange has operations abroad, firms can more easily tap capital outside their home markets.

For regulators and players in the finance business, though, mergers present a host of problems. Consider the Deutsche Börse-NYSE Euronext deal. Brokers don't like the fact that the combined group will have a hammerlock on Europe's futures markets—which they say makes it tougher for newcomers and raises the specter of high fees.

Ultimately, the merger needs a green light from European Union antitrust regulators—who have also voiced concern. Regulators formally outlined their objections to the deal last week.

Derivatives

Regulators also hold the key to giving exchanges vast new access to the over-the-counter derivatives market—something they've long craved as a lucrative new source of income. Over-the-counter derivatives are customized financial contracts that offer protection against events like changes in key interest rates. They are originated by dealer banks, which sell them to customers like insurance companies and trade them among each other. The value of all such instruments traded off exchanges: a staggering $601 trillion.

Now rule makers are pushing big banks to shunt more derivatives business to exchange-like platforms. Authorities are under pressure to tighten trading practices in derivatives markets, and exchanges seem to offer a cure for the systemic risk in complex instruments. During the 2008 credit crisis, the exchanges' trading systems held up under stress, and customers were insulated from one another's losses through a practice called clearing. In this process, big firms pledge collateral against futures and options trades. Exchanges pool collateral in a clearinghouse and draw upon it in the event a major trader fails and its losses need to be made up. The idea is to spread out the risk of default, ensuring one firm's failure doesn't create a domino effect.

A shift to clearing and more electronic trading could mean big changes for the derivatives business. Pricing could become more competitive, but smaller banks and brokers that do sizable trade in such instruments could wind up having to post more collateral to carry out the same amount of business. Corporate hedgers may see costs rise as dealers compensate for the collateral rules.

Already, derivatives exchanges like IntercontinentalExchange and CME Group have developed similar services for these markets. And banks are voluntarily routing some swaps business toward clearinghouses.

But rules for making electronic trading and clearing mandatory are still being developed under the Dodd-Frank regulatory law. And Wall Street banks are revving up lobbying against an upheaval in a key profit center.
Scott O'Malia,
a commissioner on the Commodity Futures Trading Commission, the U.S. body overseeing much of the swaps market, said last month that he expected the Dodd-Frank rules to be implemented by the end of 2012 at the earliest.

If these changes go through, exchanges will face challenges as well as opportunities. The revamps will throw open competition for swaps trading and clearing to a range of brokerages and start-up firms. And some exchange customers have objected to the idea that collateral they put up against corn futures could be used to cover a bank's losses on credit-default swaps, prompting some exchanges to develop alternative options.

Other Businesses

The push into derivatives leads a range of efforts by exchanges to shift away from trading shares and into untapped segments like foreign exchange and bonds.

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Jhiob Berckheyde/Mary Evans Picture Library/Everett Collection

Like swaps, forex and fixed income are the domain of banks that earn profits from their control of the markets. Exchanges argue that they can improve these businesses by offering more transparent trading and pricing, which may attract more asset managers and individual investors. Banks say they already have the liquidity, expertise and networks in place to provide the most competitive prices. An exchange-backed platform would have to build all or part of this—and there's no pressing incentive for users to switch over.

But the exchanges have an ally—the computer-driven trading firms that over the past decade have taken over the role of floor traders, rapidly buying and selling stocks, futures and options in hopes of capturing often-tiny profits. These trading houses have dramatically reduced price spreads in stock markets and in recent years have pushed into new markets.

Exchange-backed markets could offer an easier way for such firms to trade in these markets and compete more evenly with Wall Street banks. CME's foreign-exchange futures market, powered by Chicago's cluster of high-frequency trading shops, has risen to challenge some of the largest currency-trading venues now dominated by banks.

Mr. Bunge is a reporter for The Wall Street Journal and Dow Jones Newswires in Chicago. He can be reached at jacob.bunge@dowjones.com.

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